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Accounting for Overhead | Allocation | Apportionment | Absorption | Differences

Arjun EP

Published on: January 9, 2022

Overhead | Concept of Overhead

All expenses other than direct expenses and production are overhead.

It is an aggregate of all indirect materials, indirect wages and indirect expenses.

Another name for overhead are on cost, burden cost, indirect expenses, non-productive cost, supplementary cost, logistic support cost and loading cost etc.

Definition of overhead

According to Institute of Cost and Management Account (ICMA, London), “Overhead is an aggregate of indirect materials, indirect wages and indirect expenses.”

Overheads represent fixed costs and relate to general business functions.

These costs still remain if production is shut down for a short period of time.

Some major overheads are:

Administrative overhead

General business overhead

Research overhead

Transportation overhead

Manufacturing overhead

Marketing overhead

Selling and promotional overhead etc.

Keep in mind

Classification of overhead

Classification means put into a group, class, division etc.

Overhead means related to ongoing cost.

Therefore, classification of overhead means expenses are classified into different group.

Some importance classifications of overhead are as:

Classification by elements or nature.

Classification by function.

Classification on the basis of variability.

Classification on the basis of controllability.

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Basis of Apportionment

Apportionment means distribute, sharing and allotment.

When one cost is related to more than one cost center, this amount should be apportioned in proper basis.

This basis is pre-determined.

While selecting basis, it should be scientific.

Example:

Suppose the college where you study there is only main electricity meter.

Electricity charge (bill or expense) for particular month is $3,500.

What is the electricity charge of your class room?

Answer:

There are different options for electricity expense distribution or allocation.

They are room basis, hours of class running basis, number of light point basis etc.

To choose best alternative is base of apportionment.

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Primary Distributions

Normally, overhead is primary distribution for different department.

The best basis is chosen and overhead allocated in proportion.

Bases of Allocation of Overheads

Bases of Allocation	Overheads
Number of employees	canteen expenses
	welfare
	supervision
	insurance of staff
	personnel (recruit) office
	general expenses

Direct wage	indirect wage
	provident fund
	compensation fund
	holiday pay
	amenities (facilities)

Indirect wage	direct wage

Indirect expenses	direct expenses

Indirect overhead	direct overhead

Floor space or area	rent and other building area
	lighting and heating
	air conditioning
	fire pre-caution service
	depreciation on building

Direct materials handling	materials handling
	store keeping
	store overhead
	weight or volume of materials

Direct labour	general overhead
	sundry expenses or overhead

machine hour	repairs and maintenance
	machine related expenses

No. of light point	electricity
	lighting power

Horse power	power or electric power
	steam power

Capital or book value	depreciation on plant and machinery
	repairs and maintenance

Sales or total cost	selling and distribution expenses
	audit fees

Secondary Distribution

The process of apportioning service department expenses among the production departments is called secondary distribution.

In other words, secondary distribution is the reapportionment of service department expenses among the production departments after completion of primary distribution.

Definition of apportionment

According to ICMA, London, “Cost apportionment is the allotment of production of items of cost to cost center or cost units.”

Some common secondary distributions are as follows:

Direct distribution method

Under this method, the costs of service department are NOT distributed or apportioned to production department.

Overcharge and under charge is ignored. [See PROBLEM & SOLUTION: 1A, 1B]

Step method

Under this method, the costs of service department are distributed or apportioned production department step by step or one by one. [See PROBLEM & SOLUTION: 2A, 2B, 2C, 2D]

Reciprocal method

When overhead of one service department distributed to other service department then distributed to production department is known reciprocal method.

Although reciprocal method is the most accurate method yet it is also the most complicated.

Repeated redistribution method

Under repeated redistribution method, first of all, the total overhead costs are written below the respective departments.

Then as per the percentage given for distribution of service department costs, the apportionment is made to production departments.

Keep in Mind (KIM)

Reciprocal method is not in syllabus that is why not shown in illustration.

Allocation of Overhead

Allocation of overheads is the process of identification the overhead of a particular cost center, job or department.

In other words, whole or undivided expenses are written to a particular cost center, job or department.

When overhead expenses have been collected, they have to be allocated to related departments.

For example, overtime paid to the workers of ‘Department A’ should be allocated to ‘Department A’.

Definition of allocation

According to ICMA, London, “Cost allocation is the allotment of whole items of cost to cost center or cost units.”

Importance of allocation of overheads

The main importance of allocation of overhead are:

It helps to separate correct overhead for correct department.

It provides cost information to the management for important decisions.

It helps to minimize the wastage of resources.

It provides guideline to estimate cost of future line-of-activities.

It helps to minimize cost of output.

Apportionment of Overhead

According to given data of the overhead, some overhead are distributed directly, some in ratio, some in percentage, some in based on other overhead etc.

For the apportionment of overhead expenses, the departments of a factory are divided into two categories.

They are production departments and service departments.

Production departments

Production departments are directly engaged in manufacturing products.

For example: in a garment factory, production may be shared across the cutting, stitching, finishing and packing departments.

Service departments

Service departments do not perform operations on products to be manufactured.

But, they provide auxiliary services to support the production departments.

These services include repairs and maintenance, purchasing of parts, storeroom, training and payroll.

Generally, there are three methods to apportionment of overhead; they are:

Direct distribution method

Under this method, the costs of service department are distributed or apportioned to production department.

Overcharge and under charge is ignored.

Step method

Under this method, the costs of service department are distributed or apportioned production department step by step or one by one.

Reciprocal method

When overhead of one service department distributed to other service department; then distributed to production department, it is known reciprocal method.

Definition of apportionment

According to ICMA, London, “Cost apportionment is the allotment of production of items of cost to cost center or cost units.”

Keep in Mind (KIM)

Reciprocal method is not in syllabus that is why not shown in illustration.

Importance of apportionment of overhead

The main apportionments of overhead expenses are as follows:

It helps to find out correct cost of products for different cost centers

It provides cost information to the management for important decisions.

It helps to minimize the wastage of resources.

It provides guideline to estimate cost of future line-of-activities.

It helps to minimize cost of output.

Absorption of Overhead

Absorption means charging or sharing overhead to different cost units.

In other words, charging or sharing overhead to specific product or individual units is known absorption.

Definition of absorption

According to ICMA, “The allotment of overhead to cost unit is known as overhead absorption.”

Absorption of overheads charges to individual products or jobs.

It is a process of distribution of overheads allotted to a particular department or cost center over the units produced.

The absorption of overhead is done by applying overhead absorption rates.

In most cases, the rates are predetermined.

The overhead to be absorbed by a particular cost unit will be calculated by dividing the producing cost center overhead for a period by the cost units produced by that center in the period.

When a cost center produces dissimilar units (jobs to customer order) the volume of production must be expressed in a common measurement; they are direct labour hours, machine hours etc.

When a cost unit passes through several centers, the overhead absorbed should be separately for each center.

Methods of absorption

There are different methods of absorption of overhead; they are:

Cost per unit of output or production unit

Percentage of direct materials cost

Percentage of direct labour cost

Percentage of prime cost

Labour hour rate

Machine hour rate

Sales price method

[See PROBLEM & SOLUTION: 3A, 3B, 3C, 3D, 3E, 3F]

Differences between allocation and apportionment

Allocation is the process of identification of overhead with cost center.

Apportionment means the expenses which cannot identify wholly with a particular department.

The different are:

Bases	Allocation	Apportionment
Direct or indirect	Allocation is a direct process.	Apportionment is an indirect process.
Basis	Some of allocations are directly allocated.	Apportionment needs a suitable basis for sub-division of overhead.
Whole or part	Allocation deals with whole item of overhead.	Apportionment deals with the proportion of item of cost.
Limit	Allocation is wider and accurate than apportionment.	Apportionment is less accurate than allocation.
Staring and end	Allocation ends with a cost center.	The process of apportionment is carried further down.